Monday, July 1, 2013

The central bank of central banks,
the Bank for International Settlements or BIS has recently published its Annual
Report for 2012 - 2013. In this report, the BIS
looks at the actions of the world's central banks since the worldwide financial
crisis began in 2007 and the effectiveness of the banks prolonged period of low
interest rates and record-high balance sheets.

In the five year period since 2007,
central banks were forced to "do whatever it took" to prevent the
collapse of the financial system through two means:

1.) Lowering policy rates to zero.

2.) Expanding their balance sheets to
what is now, in total, three times the pre-crisis level.

The first action, lowering policy rates,
was intended to prevent the impending collapse of the world economy. Here
is a graph showing what has happened to policy rates in both advanced and
emerging economies as the crisis took hold:

Since then, the goal of central bank
policy has changed; the expansion of central bank balance sheets has been used in a
desperate effort to prod the world's sluggish economy back to life and to
achieve some semblance of strong, sustainable growth. Here is a graph
showing what has happened to central bank total assets/balance sheets:

Here is a graph showing the
composition of the balance sheets of the Federal Reserve, the Bank of England,
the Bank of Japan and the Eurosystem:

Note that total central bank balance
sheets were approximately $8 trillion in 2007 and that they now sit just above
$20 trillion, more than the GDP of the United States. Outside of the
advanced economies, the central banks of the emerging economies have
accumulated massive foreign exchange reserves to prevent appreciation of their
currencies. The total stock of these foreign reserves is now more than $5
trillion or about half of the world's total stock of foreign reserves.

Here's a paragraph from the first
chapter showing us where the problems still lie and who will be to blame when
things don't turn around before the next economic slowdown hits:

"What central bank accommodation has done during the recovery is to
borrow time – time for balance sheet repair, time for fiscal consolidation, and
time for reforms to restore productivity growth. But the time has not been
well used, as continued low interest rates and unconventional policies have
made it easy for the private sector to postpone deleveraging, easy for the
government to finance deficits, and easy for the authorities to delay needed
reforms in the real economy and in the financial system. After all, cheap
money makes it easier to borrow than to save, easier to spend than to tax,
easier to remain the same than to change." (my bold)

The authors of the report note that
in some countries, households have made some improvements to their balance
sheets, however, the same cannot be said for governments. The government
sector seems to be waiting for economic growth to reduce their debt-to-GDP
levels, doing the heavy lifting for them, rather than showing budgetary
discipline.

The report notes that central bank
policies have become less effective "at the margins". For
example, there is normally a hefty interest rate premium attached to long-term
bonds; this premium is now highly negative in other words, the spread between short-term and long-term interest rates is highly compressed. The prolonged low interest
rate policy has had other side effects including:

1.) Excessive risk-taking and
distortions in the prices of financial instruments in the marketplace.

2.) Sending signals to various
sectors of the economy that it is not necessary to repair balance sheets.

So, what does the report recommend
as an exit strategy now that central banks may well have painted themselves
into a policy corner? Central banks will have to balance the risk of
exiting early with the risk of delaying exiting. The issue is even more
complex than in the past when central banks simply raised interest rates; this
time, there are two complicating factors:

1.) The size of the central banks cumbersome
balance sheets.

2.) The extremely high levels of government debt that was issued at fire
sale interest rates.

Let's close with another paragraph
from the report:

"Alas, central banks cannot do more without compounding the risks they
have already created. Instead, they must re-emphasise their traditional focus –
albeit expanded to include financial stability – and thereby encourage needed
adjustments rather than retard them with near-zero interest rates and purchases
of ever larger quantities of government securities. And they must urge
authorities to speed up reforms in labour and product markets, reforms that
will enhance productivity and encourage employment growth rather than provide
the false comfort that it will be easier later." (my bold)

5 comments:

I used to worry about this more, but I'm started to wonder whether the Central Banks actually do give us a free lunch during recessions like this.

They buy up government debt with printed money, so it's the government owing the government. Seems to me that the government can forgive its debt to itself. Other entities can't count on their debt being forgiven in this way.

The usual worry in this scenario (lots of borrowing, lots of printing) is hyperinflation, but we haven't had that in commodities. I think it's possible that since we haven't printing way too much money in this recession, we're getting away with it.

Not that I'm ignoring the crap that happened with the loose monetary policy in the 00's. That caused a horrible bubble, with a terrible aftereffects. However, we don't have signs of a bubble now, just a lot of reluctance to invest.

So, I don't see any warning signs of impending doom. I know I'm supposed to (that's the orthodoxy), but honestly the warning signs aren't there.

well carney & ecb stated low interest rates bec the fed told them that their intentions back-fired. what the fed is now realizing that the street will RIP them OFF aka drexel in 90s or LTCM in 98 when they try to exist.

that is the REAL problem. plus you have the hedgies who are designed to exploit weakness esp their hiring of sell-side dorks means more trouble.

PIMCO& bluecrest problems tells you how MUCH a surprise FED statements were...

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.